DR 045: How to Diversify Investments When You’re Just Starting to Invest

New investors face unique obstacles. There’s the learning curve. Clear that and there’s still the hurdle of having little money to invest (although there are easy solutions to that one). And then there’s the question of executing an asset allocation plan when you have little capital.

That’s the question a reader named Daniel recently asked:

I have a quick question I was hoping you could address on a podcast or maybe answer in an email. Before I give details of my situation, I’ll go ahead and ask the question up front: if I don’t have enough money to purchase the minimum required by Vanguard, Fidelity, or Schwab for their mutual funds and establish asset allocation at the same time, is it okay to slowly purchase equivalent EFTs until I have the minimum investment required by the mutual funds?

Daniel’s predicament is not uncommon. Vanguard’s mutual funds generally require a minimum deposit of $3,000. A core asset allocation generally involves at least three mutual funds: a U.S. equities fund, a U.S. bond fund, and a foreign fund. You can check out my podcast on asset allocation for more details. But the point is that with just three funds you’d need $9,000 just to get started.

Daniel’s solution is to invest in ETFs instead of mutual funds. While ETFs typically have brokerage fees, and bid/ask spreads, the minimum is typically one share. Thus, you could implement your asset allocation plan with ETFs when you are just starting out to avoid the minimum investment requirements of many mutual funds.

We’ll examine Daniel’s solution, as well as several other alternatives you can consider.

Before we delve more into this common problem, I should say that this isn’t a problem for 401(k)s. When you have a 401(k) from your job, there are no minimums. In your 401(k), you should be able to invest in any of the funds that they have with your monthly contribution, and you can slice and dice your contributions into whatever funds you want. So that’s the good news.

However, if you’re opening up an IRA or a Roth IRA, then you can have this problem. How do we get around it?

There are four potential ways to deal with this problem.

1. My solution

When I first started investing outside of my 401(k), I, like Daniel, didn’t have the money to go out and buy the minimums required for three, four, or five funds.

My approach was to start with one fund. Yes, it’s not my perfect asset allocation, but I was starting out with $100 a month. At that time, I could invest in what was called the Legg Mason Value Trust fund run by famed money manager Bill Miller.

Was it the most perfect allocation plan? No. Did I have emerging markets, foreign funds, and a bond fund? I didn’t. I had the Legg Mason Value Trust Fund, which was basically a U.S. equity fund.

But in my view, that’s okay. You don’t have to have a perfect asset allocation plan on day one. Start with just one fund. And then when you have enough money to buy into a bond fund or a foreign fund, do that. And add mutual funds and diversification as your assets grow.

If I were taking this approach today, I’d start with the Vanguard S&P 500 mutual fund (ticker: VFINX). This fund does require a $3,000 minimum. To achieve that, I’d simply save money in a high interest FDIC insured savings account until I reached this minimum.

2. ETFs

The second option gets into Daniel’s question about ETFs. I have covered ETFs and how they’re different from mutual funds. But, as per Daniel’s question, ETFs are an option. As noted above, unlike most mutual funds, they don’t have a minimum investment requirement. For example, with Vanguard, you can purchase just a single share. And a single share of an ETF is going to be under $100. Even with $1,000, you can invest in a number of ETFs that are virtually identical to the mutual funds.

There are some potential pitfalls with ETFs. First, in most cases, you have to pay a brokerage fee when you buy an ETF just like you do when you buy an individual stock. As you’re investing small amounts of money, those brokerage fees could make this option a non-starter.

The second problem is bid-ask spreads on ETFs. There is a difference between what you pay and what the seller receives. The spread varies depending on the ETF. Regardless, it’s another cost that you have to pay when you buy an ETF.

The third potential downside is that ETFs generally don’t automatically re-invest your dividends for you. They go into a cash account associated with your brokerage account, and you then have to reinvest the cash on your own. And, of course, if you’re re-investing in ETFs, you’re right back to paying brokerage fees and the bid-ask spread.

Having said all of that, there are some solutions. Vanguard is one of them. Vanguard does not charge brokerage fees if you buy Vanguard ETFs. There’s still going to be the bid-ask spread, but this will cut your costs some.

Also, expense ratio of Vanguard’s ETFs is lower than the investor class share of their mutual funds, which is what you buy if you invest $3,000. Again, this makes it more affordable to invest in ETFs with Vanguard. Also, Vanguard does reinvest the dividends for you. So Vanguard does overcome some of these hurdles that you might have buying ETFs somewhere else.

If you can get a good setup like this, I think ETFs are a reasonable alternative when you’re just starting out and you don’t have a whole lot to invest. But only do this if there are no brokerage fees and your dividends are automatically reinvested.

3. Betterment

The third option when you’re starting out is to try something like Betterment. If you listened to the 31-Day Money Challenge, you’re familiar with Betterment. I have a taxable account with Betterment and make monthly automatic contributions of just $100.

Betterment takes your investments and spreads them out over a number of ETFs, including Vanguard ETFs. They rebalance your portfolio automatically based on how much you want invested in stocks and how much in bonds. And they reinvest your dividends as well.

You can open an account at Betterment and get started with very little money. I’ve been happy with my account at Betterment. I started it as a kind of experiment, and set up an automatic deposit that goes into my account there every month. I’ve been very happy with it, and it’s very easy to use.

4. A Fund of Funds

The fourth and final option is a fund of funds. I’ve talked about this in the 31-Day Money Challenge, too, particularly on days 25 (asset allocation) and 26 (picking mutual funds). Mutual fund companies will offer a single fund that you can invest in, and they will take your money and spread it out over a number of their funds to give you instant diversification.

Vanguard offers these, as does Fidelity. So you just have to deal with the minimum for that one fund. For Vanguard, it’s $3,000. Once you do that, you have your money invested in a number of funds at Vanguard automatically.

These funds automatically rebalance within the fund. So with just a $3,000 minimum, you could get great exposure to foreign funds, U.S. equities funds, and U.S. bond funds.

Vanguard calls these ‘all-in-one’ funds. They have some that are specifically designed for retirement, where you invest in the fund that’s geared towards the year you’re going to retire. As time goes by, the fund will change your asset allocation to make it a little more conservative as you get closer to retirement.

They also offer what’s called a Life Strategy fund, where you can pick among four different asset allocations, ranging from 20% stocks/80% bonds to 80% stocks/20% bonds. Vanguard then takes your money and invests it in several of their funds for you. This is the same strategy, except that your asset allocation doesn’t change over time.

But there are some limitation here. For one, you have to accept the asset allocation that Vanguard has set up for these funds. For instance, they don’t offer a 100% stocks option in a Life Strategy fund. Their most aggressive option is 80% stocks/20% bonds.

While this option has limitations, it’s a great way to get started investing. You can find out more about Vanguard’s fund options here.

Your choices

Most people just starting to invest don’t have a whole lot of money. And it’s intimidating trying to figure out how to do this. But if you just spend some time with it, and consider the above suggestions, there are some pretty simple solutions to these problems.

Once you’ve saved up for a while, you’ll have enough to open up different mutual funds – if that’s what you want to do. Or you might just end up sticking with one of these options. I think either way is fine, as long as you keep your costs low and invest primarily in passively managed index funds.

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

Kurtsays:

March 24, 2014 at 11:21 am

Looks like this podcast is actually a copy of the 0% credit card podcast. On iTunes as well.

Kurt, thanks for letting me know. Looking into the issue now. Update. Just found and fixed the problem. It may take some time to replicate to iTunes, but it’s correct now on the site. Thanks again for bringing this to my attention!

There are nearly equivalent index funds like Schwabs that have different requirements for IRAs vs. non-IRAs that start at $100, that maybe a good start for some and without commissions and allow for automatic periodic investments.

Thanks for a great podcast! Really appreciate you taking the time to share your knowledge.

One question which came to mind regarding asset allocation, and specifically rebalancing: Suppose my asset allocation is off, as the value of the index fund which tracks my home country’s index has seen huge growth during 2013, resulting in it now being 40 per cent of my investments (thanks to capital appreciation) as opposed to 30 per cent, which I was going for. The common solution seems to be to sell enough of said fund to bring my investment in said fund down to 30 percent of my investments. But why not just allocate less of future investments (I dollar cost average) towards that fund, and more towards the underweighted funds? Will that not do the same thing over time, without having to sell anything yet?I will not use the money for another 15 years at least, so selling now seems unnecessary.

Helen, changing your future investments is a great way to rebalance. I do that all the time. It may take some time to get your portfolio back to your target asset allocation. But if it’s not too long, I think that’s a fine approach. And if you have investments in taxable accounts, it helps avoid the tax consequences of selling investments to rebalance.

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